Hedge funds are private companies that pool investors’ dollars and reinvest them in complicated financial instruments to outperform the market. Investors expect them to generate high returns, regardless of how the market does.
Note: The term “hedge fund” first came up in the 1940s. Alternative investor Alfred Winslow Jones originally created this type of fund that sold short shares as part of its investment strategy.
The assets managed by hedge funds have increased over the years, and the estimate reaches $ 3.0 billion in the third quarter of 2019. This article provides a detailed description of how hedge funds work, who invests in them.
What is the hedge fund investing?
An investment in hedge funds is a group of investments contributed by a limited number of partners (investors) and operated by a professional administrator with specific objectives in mind, mainly to maximize returns and minimize risks. And, due to their nature, hedge funds are generally open only to qualified investors. However, they are not exclusively institutions, investors with connections to the manager or even the managers themselves also invest frequently.
Hedge funds generally have a wide range of securities in which they are invested and, although not all, are required to register with the US Stock Exchange Commission. (SEC), large hedge fund managers and some other exceptions should be noted. When the investment structure is created, it is usually structured in two ways: as a limited partnership (LP) or a limited liability company (LLC). The first is a structure in which partners are responsible only for the amount they invest personally. In contrast, the second is a corporate structure in which investors cannot be individually accountable (or responsible) for the company’s responsibilities.
How do hedge funds work?
Hedge funds are configured as limited partnerships or limited liability companies, which offer direct tax treatment and limited personal liability to managers and partners. The hedge fund’s legal documents describe how the fund is structured and can explain what the manager can invest in.
These legal documents also provide information on how managers are paid. Hedge fund managers receive an annual management fee. They can receive a performance fee if they reach a benchmark called the obstacle rate. Most managers were paid according to the “two and twenty” rule. This represents 2% per annum of the management fee’s total assets, plus 20% of profits above the rate of performance fee hurdles.
Some investors have recently started paying some of the new hedge funds a lower amount in commissions. They seem to follow the “1.4 and 17” rule, that is, 1.4% per year of the management fee’s total assets, plus 17% of the gains in the performance fee obstacle rate.
How to invest in a hedge fund
Before investing in a hedge fund, you must ensure that you are prepared and suitable (financially) for the company. The obvious way to do this is to ensure that you meet the “accredited” standards for hedge fund investors mentioned above.
However, it would help if you also decided how aggressive and risky you want to be, what you would like to invest in, and your goals. When researching different funds, consider these goals when choosing the one that best suits your wishes and capital availability.
Types of hedge funds
As mentioned earlier, a hedge fund’s main objective is to minimize risk and maximize profits for its investors. However, there are several different types of strategies for hedge funds that do different things. The hedge fund’s objectives will determine its investments. Some of the most common ones include macro or global hedge funds and equity funds.
1. Macro hedge funds:
Some hedge funds, such as macro hedge funds, invest in stocks, bonds, futures, options, and sometimes currencies, with the hope of maximizing changes in macroeconomic variables, such as world trade, interest rates, or policies. These types of investments are generally very leveraged and very diverse. Historically, however, these types of funds have been the most significant setback (like long-term capital management).
2. Equity hedge funds (long/short):
Another type of hedge fund called a hedge fund (also known as long/short stocks), tries to protect itself against the fall of the stock markets by investing in stocks or stock indexes and shortening them (if overvalued).
However, in a long/short hedge fund, managers invest in undervalued stocks and divide the investment between long-term investments in stocks and shorten other stocks. For example, the fund could have 60% of its funds invested in long-term stocks and 40% in short-term stocks, leaving a net exposure to the stock market of 20% (60% -40% = 20%, but maintaining 100% gross exposure to avoid leverage). However, if the fund manager decides to invest 70% in shares and keep 40% in short shares, the total exposure would increase to 110% (with a 10% leverage).
3. Relative Value Arbitrage Hedge Funds:
These hedge funds generally buy securities that are expected to appreciate and, at the same time, sell a similar value (such as shares or protection of a different company in the same or similar sector) that is expected to depreciate.
4. Distressed Hedge Funds:
Despite the title, these funds have no problems; they get involved in payments or loan restructuring frequently. These funds can even help companies manage by buying bonds (such as bonds that have lost value due to financial instability within the company) in the hope that they will appreciate it. Or, troubled hedge funds can buy cheap bonds if they think they will be appreciated soon; However, as you can imagine, this type of bet can be risky, as the company’s shares or bonds are not sure whether they will be valued.
Benefit from investment in hedge funds
- They are only open to “accredited” or qualified investors: hedge funds can only receive money from “qualified” investors with an annual income over $ 200,000 in the past two years or net worth over $ 1 million, excluding your primary residence. As such, the Securities and Exchange Commission considers that qualified investors are adequate to deal with the potential risks arising from a broader investment mandate.
- They offer greater investment freedom than other funds: the investment universe of a hedge fund is limited only by its order. A hedge fund can invest in land, real estate, stocks, derivatives, and currencies. Investment funds, on the other hand, basically have to stick to stocks or bonds and, in general, are long-term.
- They often use leverage: hedge funds often use borrowed money to amplify their returns. As we saw during the 2008 financial crisis, force can also eliminate hedge funds.
- Fee structure: instead of charging just an expense fee, hedge funds charge an expense fee and a performance fee. This fee structure is known as “Two and Twenty,” a 2% asset management fee and a 20% cut in any profit generated.
There are more specific characteristics that define a hedge fund, but, because they are private investment vehicles that only allow wealthy people to invest, hedge funds can do whatever they want, as long as they disclose the strategy in advance to investors. This wide latitude can seem very risky, and, at times, it can be. Some of the most spectacular financial explosions involved hedge funds. That said, this flexibility given to hedge funds has led some of the most talented cash managers to produce surprising long-term returns.
It is essential to keep in mind that “hedge” is the practice of trying to reduce risk. Still, the goal of most hedge funds is to maximize the return on investment. The name is mainly historical since the first hedge funds tried to protect against the risk of a falling market falling, shortening the market. (Investment funds generally do not go short as one of their main objectives). Today, hedge funds use dozens of different strategies, so hedge funds only cover risks. As hedge fund managers make speculative investments, these funds may present more risks than the market in general.